High-Yield Closed-End Bond Funds Are A Great Alternative To Cash In A Market Correction

Includes: CIF, EAD, FHY, GHY, HYF, ISD
by: Mitch DeVan


In recent years, the second quarter has been the weakest quarter of the year for the S&P, Dow, and Nasdaq.

Excluding increases in demand and the price of food, inflation is not present in the market.

Closed-end, high-yield bond funds offer potential for double-digit total return, as they typically trade at their net asset value during market corrections.

As the first quarter of 2014 comes to a close, caution is the word for the markets as we enter the second quarter of 2014. The second quarter has been the worst-performing quarter for the US markets in three of the past four years. The SPDR S&P 500 ETF (NYSEARCA:SPY) and PowerShares QQQ ETF (NASDAQ:QQQ) were negative for those three quarters, and both have been negative in five of the past eight second quarters.

The biotech sector is suggesting that the entire market is moving into a correction. Corrections usually begin with the most speculative sectors selling off. iShares Nasdaq Biotechnology (NASDAQ:IBB) has lost over 12% in the past month. Gold is also selling off, as it is down over 5% in the past six trading days.

Meanwhile, utility stocks are picking up strength, which is a sign of investors seeking safety as interest rates remain low and stable. With interest rates remaining low, investors may seek safety in high-yield bonds funds. Closed-end, high-yield bond funds provide a safe haven during a market correction, with the potential for double-digit returns on investment.

Being patient is the key to success during a market correction. It can be difficult to sit out of the market, with money market funds offering investors little or no return for their cash. Investors may be tempted to short the market; however, doing so is a very risky bet to make. Investors looking for a more conservative option and return on their investment during a market correction should take a look at high-yield, closed-end bond funds.

I analyzed the most recent portfolio statistics provided by the 37 taxable high-yield, closed-end funds. Searching for the best value among these funds, I was looking for funds that meet the following parameters:

  1. Trading at a minimum 5% discount to the fund's net asset value.
  2. Distribution rate of at least 8% of the current price.
  3. Minimum 80% of the fund's holdings are rated "B" or better.
  4. Portfolio leverage is between 24%-30%.
  5. Average duration of the fund's portfolio is less than 6 years.

Six of the 37 funds met the criteria.

Symbol NAV Leverage Yield Discount Duration CCC or lower
ISD $18.99 24.72% 8.23% -5.90% 2.30 10.00%
EAD $9.96 24.81% 8.65% -5.32% 4.81 20.00%
CIF $3.19 24.82% 7.86% -9.09% 5.50 20.00%
GHY $18.95 29.75% 8.47% -6.49% 2.30 7.00%
FHY $17.25 27.21% 9.07% -7.94% 4.40 20.00%
HYF $2.30 28.14% 8.41% -10.00% 5.84 12.00%

Prudential Short Duration High Yield Fund (NYSE:ISD), Wells Fargo Advantage Income Opportunities Fund (NYSEMKT:EAD), and MFS Intermediate High Income Fund (NYSE:CIF) are all made up of 100% USA holdings. ISD provides the best bang for the buck by offering the best credit quality of the three and the shortest average duration of its holdings. The fund traded at a premium to net asset value just last May, and has never lowered its dividend payment.

Prudential Global Short Duration High Yield Fund (NYSE:GHY), First Trust Strategic High Income Fund II (NYSE:FHY), and Managed High Yield Plus Fund Inc. (NYSE:HYF) all have at least a portion of their portfolios in holdings outside the USA. GHY has the best credit quality and lowest duration of the three. The fund is trading at the lowest discount to net asset value of the three; however, the fund has never reduced its dividend payments. The fund last traded at a premium to net asset value last March.

Inflation remains well below the Fed's goal, and I still do not see any signs that there will be a significant increase in long-term rates. Excluding increases in the cost of food, inflation is nonexistent. I do expect increases over the next few years, but not enough to create an interest rate shock. While I do not expect a sudden spike in interest rates, funds with shorter average durations will help absorb the potential risk of an interest rate shock.

Closed-end funds offer investors a great alternative to traditional bonds or bond mutual funds. The low average duration of ISD and GHY provides a safety net against a spike in interest rates. These two funds hold higher credit quality bonds compared to their peers, which help against the credit quality risk of high-yield bonds. At the same time, investors have the potential for double-digit total returns if the funds return to trading at or above their net asset value. Not bad for a short-duration fixed income product.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.